**U.S.SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C.  20549**

 

**FORM 10-QSB**

 

| **(Mark One)**                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |   |   |
| **ý**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |   | **Quarterly Report Under Section 13 or 15(d) of The  Securities Exchange Act of 1934** |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |   |   |
| **For the quarterly period ended    December 26, 2003**                                                                                                                                                                                                                                                                                                                                                                                                                 |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |   |   |
| **o**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |   | **Transaction Report Under Section 13 or 15(d) of the  Securities Exchange Act** |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |   |   |
| **For the transition period  from                                    to                                     ** |

 

**Commission File Number    000-04169**

 

**SYS**

(Exact Name of Small Business Issuer as Specified in Its Charter)

 

| **California**                                                  |   | **95-2467354**                        |
|-----------------------------------------------------------------|--------|---------------------------------------|
| (State or Other Jurisdiction of  Incorporation or Organization) |   | (I.R.S. Employer  Identification No.) |

 

**5050 Murphy Canyon Road, Suite 200, SanDiego, California  92123**

(Address of Principal Executive Offices)

 

**(858) 715-5500**

(Issuer’s Telephone Number, Including Area Code)

 

 

(Former Name, Former Address and Former Fiscal Year, if ChangedSince Last Report)

 

Checkwhether the issuer: (1) filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act during the past 12months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days.

 

Yes  ý   No  o

 

Statethe number of shares outstanding of each of the issuer’s classes of commonequity, as of the latest practicable date: 6,724,038 shares of common stock, without par value, as ofJanuary 28, 2004.

 

TransitionalSmall Business Disclosure Format (check one):

 

Yes  o   No  ý

 

 

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**TABLE OF CONTENTS**

 

 
| **PART I - FINANCIAL INFORMATION** |                                                                     |
|------------------------------------|--------------------------------------------------------------------------|
|                               |                                                                     |   |   |
|                               | Item 1.  Financial Statements                                            |   |
|                               |                                                                     | Condensed Consolidated Balance Sheet  December 26, 2003 (unaudited) and June 30, 2003 (audited) |   |
|                               |                                                                     | Condensed Consolidated Statements of  Operations (unaudited) Three and Six Months Ended December 26, 2003 and  December 28, 2002 |   |
|                               |                                                                     | Condensed Consolidated Statements of Cash  Flows (unaudited) Six Months Ended December 26, 2003 and  December 28, 2002 |   |
|                               |                                                                     | Notes to Condensed Consolidated Financial  Statements (unaudited) |   |
|                               |                                                                     |   |   |
|                               | Item 2.  Management’s Discussion and Analysis or Plan of Operations |   |
|                               |                                                                     |   |   |
|                               |                                                                     | New Accounting Pronouncements |   |
|                               |                                                                     | Description of Business |   |
|                               |                                                                     | Results of Operations |   |
|                               |                                                                     | Liquidity and Capital Resources |   |
|                               |                                                                     |   |   |
|                               | Item  2a. Factors Which May Affect Future Results                        |   |
|                               |                                                                     |   |   |
|                               | Item 3.  Controls and Procedures                                         |   |
|                               |                                                                     |   |   |
|                               |                                                                     |   |   |
| **PART II - OTHER INFORMATION**    |                                                                     |
|                               |                                                                     |   |   |
|                               | Item 1. Legal Proceedings                                                |   |
|                               |                                                                     |   |   |
|                               | Item 2. Changes in Securities                                            |   |
|                               |                                                                     |   |   |
|                               | Item 3. Defaults Upon Senior Securities                                  |   |
|                               |                                                                     |   |   |
|                               | Item 4. Submission of Matters to a Vote of  Security Holders             |   |
|                               |                                                                     |   |   |
|                               | Item 5. Other Information                                                |   |
|                               |                                                                     |   |   |
|                               | Item 6. Exhibits and Reports on Form 8-K                                 |   |
|                               |                                                                     |   |   |
| **SIGNATURES**                     |                                                                     |   |
|                                    |                                                                          |  |  |  |

 

2

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PART I

FINANCIAL INFORMATION

Item 1.                                                             FinancialStatements

SYS AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEET

 
|                                                                                                                                     |   | **December  26, 2003** |      | **June 30,  2003** |   |
|------------------------------------------------------------------------------------------------------------------------------------------|--------|------------------------|-----------|-------------------------|--------|
|                                                                                                                                     |   | **(Unaudited)**        |      | **(Audited)**           |   |
| ASSETS                                                                                                                                   |   |                   |      |                    |   |
| Current assets:                                                                                                                          |   |                   |      |                    |   |
| Cash                                                                                                                                     |   | $                      | 290,000   |                    | $      | 19,000 |   |
| Contract receivables, net of allowance for  doubtful accounts of $58,000 and $28,000                                                     |   | 6,672,000              |      | 5,650,000               |   |
| Deferred tax assets                                                                                                                      |   | 302,000                |      | 302,000                 |   |
| Income tax refund receivable                                                                                                             |   | 412,000                |      | 477,000                 |   |
| Inventory                                                                                                                                |   | 53,000                 |      | —                  |   |
| Other current assets                                                                                                                     |   | 176,000                |      | 149,000                 |   |
| Total current assets                                                                                                                     |   | 7,905,000              |      | 6,597,000               |   |
| Furniture and equipment, less accumulated  depreciation and amortization of $1,052,000 and $937,000                                      |   | 675,000                |      | 738,000                 |   |
| Capitalized software for internal use, net  of accumulated amortization of $27,000 and $17,000                                           |   | 75,000                 |      | 85,000                  |   |
| Deferred tax assets                                                                                                                      |   | 13,000                 |      | 13,000                  |   |
| Other assets                                                                                                                             |   | 114,000                |      | 238,000                 |   |
| Total assets                                                                                                                             |   | $                      | 8,782,000 |                    | $      | 7,671,000 |   |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                |   |                   |      |                    |   |
| Current liabilities:                                                                                                                     |   |                   |      |                    |   |
| Borrowings under bank line of credit                                                                                                     |   | $                      | 602,000   |                    | $      | 638,000 |   |
| Current portion of working capital loan                                                                                                  |   | 167,000                |      | 167,000                 |   |
| Accounts payable                                                                                                                         |   | 714,000                |      | 1,398,000               |   |
| Accrued payroll and related taxes                                                                                                        |   | 1,209,000              |      | 932,000                 |   |
| Income taxes payable                                                                                                                     |   | 267,000                |      | —                  |   |
| Other accrued liabilities                                                                                                                |   | 502,000                |      | 266,000                 |   |
| Convertible notes payable                                                                                                                |   | 119,000                |      | —                  |   |
| Current portion of capital lease  obligations                                                                                            |   | 33,000                 |      | 30,000                  |   |
| Total current liabilities                                                                                                                |   | 3,613,000              |      | 3,431,000               |   |
| Working capital loan, net of current  portion                                                                                            |   | 28,000                 |      | 97,000                  |   |
| Convertible notes payable                                                                                                                |   | 519,000                |      | 638,000                 |   |
| Convertible notes payable to related  parties                                                                                            |   | 287,000                |      | 362,000                 |   |
| Capital lease obligations, net of current  portion                                                                                       |   | 48,000                 |      | 64,000                  |   |
| Total liabilities                                                                                                                        |   | 4,592,000              |      | 4,592,000               |   |
| Stockholders’ equity:                                                                                                               |   |                   |      |                    |   |
| 9% preference stock, $1.00 par value;  2,000,000 shares authorized; 69,781 Series B shares issued and outstanding at  June 30, 2003 |   | —                 |      | 70,000                  |   |
| Common stock, no par value; 48,000,000  shares authorized; 6,213,662 and 5,525,790 shares issued                                         |   | 3,704,000              |      | 2,710,000               |   |
| Common stock to be issued for accrued  liability                                                                                         |   | —                 |      | 82,000                  |   |
| Retained earnings                                                                                                                        |   | 583,000                |      | 217,000                 |   |
| Total stockholders’ equity                                                                                                          |   | 4,287,000              |      | 3,079,000               |   |
|                                                                                                                                     |   | $                      | 8,782,000 |                    | $      | 7,671,000 |   |

 

See accompanying Notes to Condensed Consolidated Financial Statements.

 

3

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SYS AND SUBSIDIARIES

CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

 
|                                                                                               |   | **Three  months ended**     |      | **Six months  ended**       |   |
|----------------------------------------------------------------------------------------------------|--------|-----------------------------|-----------|-----------------------------|--------|
|                                                                                               |   | **December 26,  2003** |      | **December 28,  2002** |   | **December 26,  2003** |   | **December 28,  2002** |   |
| Contract revenues                                                                                  |   | $                           | 7,658,000 |                        | $      | 6,830,000 |   | $ | 15,210,000 |   | $ | 11,911,000 |   |
|                                                                                               |   |                        |      |                        |   |   |   |   |   |
| Costs and expenses:                                                                                |   |                        |      |                        |   |   |   |   |   |
| Contract costs                                                                                     |   | 6,152,000                   |      | 5,635,000                   |   | 12,512,000 |   | 9,773,000 |   |
| General and administrative expenses                                                                |   | 1,088,000                   |      | 695,000                     |   | 2,023,000 |   | 1,392,000 |   |
| Legal settlement                                                                                   |   | —                      |      | 941,000                     |   | — |   | 941,000 |   |
|                                                                                               |   | 7,240,000                   |      | 7,271,000                   |   | 14,535,000 |   | 12,106,000 |   |
| Income (loss) from operations                                                                      |   | 418,000                     |      | (441,000                    | )      | 675,000 |   | (195,000 | ) |
|                                                                                               |   |                        |      |                        |   |   |   |   |   |
| Other (income) expenses:                                                                           |   |                        |      |                        |   |   |   |   |   |
| Interest income                                                                                    |   | (17,000                     | )         | (3,000                      | )      | (31,000 | ) | (4,000 | ) |
| Interest expense                                                                                   |   | 28,000                      |      | 54,000                      |   | 66,000 |   | 107,000 |   |
|                                                                                               |   | 11,000                      |      | 51,000                      |   | 35,000 |   | 103,000 |   |
| Income (loss) from continuing operations  before income taxes                                      |   | 407,000                     |      | (492,000                    | )      | 640,000 |   | (298,000 | ) |
| Income tax provision (benefit) from  continuing operations                                         |   | 170,000                     |      | (197,000                    | )      | 270,000 |   | (119,000 | ) |
| Income (loss) from continuing operations                                                           |   | 237,000                     |      | (295,000                    | )      | 370,000 |   | (179,000 | ) |
| (Loss) from discontinued operations (less  applicable income tax benefit of $152,000 and $188,000) |   | —                      |      | (227,000                    | )      | — |   | (281,000 | ) |
| Net income (loss)                                                                                  |   | $                           | 237,000   |                        | $      | (522,000 | ) | $ | 370,000 |   | $ | (460,000 | ) |
|                                                                                               |   |                        |      |                        |   |   |   |   |   |
| Income (loss) from continuing operations                                                           |   | $                           | 237,000   |                        | $      | (295,000 | ) | $ | 370,000 |   | $ | (179,000 | ) |
| Preference dividend requirements                                                                   |   | 1,000                       |      | —                      |   | 4,000 |   | 3,000 |   |
| Net income (loss) applicable to common  stock attributable to continuing operations                |   | 236,000                     |      | (295,000                    | )      | 366,000 |   | (182,000 | ) |
| Net (loss) applicable to common stock  attributable to discontinued operations                     |   | —                      |      | (227,000                    | )      | — |   | (281,000 | ) |
| Net income (loss) applicable to common  stock                                                      |   | $                           | 236,000   |                        | $      | (522,000 | ) | $ | 366,000 |   | $ | (463,000 | ) |
|                                                                                               |   |                        |      |                        |   |   |   |   |   |
| Basic net income (loss) per common share  from continuing operations                               |   | $                           | 0.04      |                        | $      | (0.06 | ) | $ | 0.06 |   | $ | (0.04 | ) |
| Basic net (loss) per common share from  discontinued operations                                    |   | —                      |      | (0.04                       | )      | — |   | (0.05 | ) |
| Basic net income (loss) per common share                                                           |   | $                           | 0.04      |                        | $      | (0.10 | ) | $ | 0.06 |   | $ | (0.09 | ) |
|                                                                                               |   |                        |      |                        |   |   |   |   |   |
| Diluted net income (loss) per common share  from continuing operations                             |   | $                           | 0.03      |                        | $      | (0.06 | ) | $ | 0.05 |   | $ | (0.04 | ) |
| Diluted net (loss) per common share from  discontinued operations                                  |   | —                      |      | (0.04                       | )      | — |   | (0.05 | ) |
| Diluted net income (loss) per common share                                                         |   | $                           | 0.03      |                        | $      | (0.10 | ) | $ | 0.05 |   | $ | (0.09 | ) |

 

See accompanying Notes to Condensed Consolidated Financial Statements.

 

4

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SYS AND SUBSIDIARIES

CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

 
|                                                                                                                  |   | **Six months  ended**       |    |
|-----------------------------------------------------------------------------------------------------------------------|--------|-----------------------------|---------|
|                                                                                                                  |   | **December 26,  2003** |    | **December 28,  2002** |   |
| Operating activities:                                                                                                 |   |                        |    |   |   |
| Net income (loss)                                                                                                     |   | $                           | 370,000 |   | $ | (460,000 | ) |
| Adjustments to reconcile net income to net  cash provided by (used in) operating activities of continuing operations: |   |                        |    |   |   |
| Loss from discontinued operations                                                                                     |   | —                      |    | 277,000 |   |
| Depreciation and amortization                                                                                         |   | 125,000                     |    | 98,000 |   |
| Deferred income taxes                                                                                                 |   | —                      |    | (111,000 | ) |
| Increase in allowance for doubtful accounts                                                                           |   | 30,000                      |    | — |   |
| Accretion of debt discount                                                                                            |   | —                      |    | 22,000 |   |
| Changes in operating assets and  liabilities:                                                                         |   |                        |    |   |   |
| Contract receivables                                                                                                  |   | (1,052,000                  | )       | (2,060,000 | ) |
| Income tax refund receivable                                                                                          |   | 65,000                      |    | — |   |
| Other current assets                                                                                                  |   | (27,000                     | )       | (451,000 | ) |
| Inventory and other assets                                                                                            |   | 71,000                      |    | (70,000 | ) |
| Accounts payable                                                                                                      |   | (684,000                    | )       | 1,252,000 |   |
| Accrued payroll and related taxes                                                                                     |   | 445,000                     |    | 170,000 |   |
| Accrued legal settlement                                                                                              |   | —                      |    | 750,000 |   |
| Income taxes payable                                                                                                  |   | 267,000                     |    | — |   |
| Other accrued liabilities                                                                                             |   | 236,000                     |    | 208,000 |   |
| Net cash used in operating activities of  continuing operations                                                       |   | (154,000                    | )       | (375,000 | ) |
| Net cash used in discontinued operations                                                                              |   | —                      |    | (206,000 | ) |
| Net cash used in operating activities                                                                                 |   | (154,000                    | )       | (581,000 | ) |
| Investing activities - Acquisition of  furniture and equipment                                                        |   | (52,000                     | )       | (204,000 | ) |
| Financing activities:                                                                                                 |   |                        |    |   |   |
| Net line of credit borrowings (payments)                                                                              |   | (36,000                     | )       | 698,000 |   |
| Payments of related party note payable                                                                                |   | —                      |    | (28,000 | ) |
| Payments of notes payable                                                                                             |   | (69,000                     | )       | (66,000 | ) |
| Payments of capital lease obligations                                                                                 |   | (13,000                     | )       | (31,000 | ) |
| Payments of dividends on preference stock                                                                             |   | (4,000                      | )       | (3,000 | ) |
| Cash paid due to call on preference stock                                                                             |   | (60,000                     | )       | — |   |
| Proceeds from convertible notes payable                                                                               |   | 150,000                     |    | — |   |
| Proceeds from issuance of common stock                                                                                |   | 509,000                     |    | 30,000 |   |
| Net cash provided by (used in) financing  activities                                                                  |   | 477,000                     |    | 600,000 |   |
| Net increase (decrease) in cash                                                                                       |   | 271,000                     |    | (185,000 | ) |
| Cash at beginning of period                                                                                           |   | 19,000                      |    | 260,000 |   |
| Cash at end of period                                                                                                 |   | $                           | 290,000 |   | $ | 75,000 |   |
| Supplemental disclosure of cash flow data:                                                                            |   |                        |    |   |   |
| Interest paid                                                                                                         |   | $                           | 38,000  |   | $ | 73,000 |   |
| Income taxes paid                                                                                                     |   | $                           | —  |   | $ | 73,000 |   |
| Supplemental disclosure of noncash  investing and financing activities:                                               |   |                        |    |   |   |
| Offset of subscriptions receivable from  Company officers with accrued compensation                                   |   |                        |    | $ | 45,000 |   |
| Common stock issued upon exercise of  convertible note                                                                |   | $                           | 225,000 |   |   |   |
| Common stock issued upon conversion of  preference stock                                                              |   | $                           | 10,000  |   |   |   |
| Common stock issued for accrued liability                                                                             |   | $                           | 82,000  |   |   |   |
| Common stock issued to ESOP as contribution                                                                           |   | $                           | 168,000 |   |   |   |
| Common stock held in treasury, retired                                                                                |   | $                           | 198,000 |   |   |   |

 

See accompanying Notes to Condensed Consolidated Financial Statements.

 

5

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SYS ANDSUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIALSTATEMENTS

 

(1)          General

 

In the opinion of the Management, theunaudited financial information in this report reflects all adjustments,consisting only of normal recurring accruals, which are considered necessaryfor a fair presentation of the consolidated financial position of SYS andsubsidiaries as of December 26, 2003 and the consolidated results of operationsand cash flows for the periods shown. Certain information and footnote disclosures normally included in theconsolidated financial statements prepared in conformity with accountingprinciples generally accepted in the United States of America have beencondensed or omitted pursuant to SEC regulations.  It is suggested that these financial statements be read inconjunction with the audited financial statements included in the Company’sReport on Form 10-KSB for the fiscal year ended June 30, 2003.

 

The preparation of financial statements in conformitywith generally accepted accounting principles requires management to makeestimates and assumptions that affect the reported amounts of assets andliabilities and disclosure of contingent assets and liabilities at the date ofthe financial statements and the reported amounts of revenues and expensesduring the reporting period. Actual results could differ from those estimates.

 

The results of operations for the six monthsended December 26, 2003 are not necessarily indicative of the results to be expectedfor the full year ending June 30, 2004.

 

The Company’s fiscal year is from July 1through June 30.  The Company uses the5-4-4 weeks per period method for each quarter; periods one (July) and twelve(June) may vary slightly in the actual number of days due to the beginning andend of each fiscal year.

 

In fiscal years prior to 2003, theCompany identified and reported on two industry segments, SYS Division andTestmasters Division.  The SYS Divisionwhich works primarily as a contractor for U.S. defense contractors and the U.S.Government, and the Testmasters Division which primarily provided softwaretesting services to industry.  TheCompany ceased reporting the Testmasters Division as a segment after the firstquarter of 2003 as the business was included in the Integrated InformationSolutions (IIS) Division.  EffectiveJune 30, 2003, the Company consolidated its Training business with theTestmasters business and then sold the combined businesses.  Additionally, during 2003, the Companystarted the Walk Up Systems Division, which was discontinued as of June 30,2003.  The condensed consolidatedfinancial statements have been restated to reflect the results of operationssold or discontinued businesses as discontinued operations in accordance with SFASNo. 144.

 

Substantially all of the Company’s operationsare conducted in the United States.

 

Certain amounts in the FY 2003 condensedconsolidated financial statements have been reclassified to conform to the FY2004 presentation.

 

(2)                                  Stock-Based Compensation

 

The following table summarizes certaininformation regarding stock options issued under the SYS 1997 Incentive StockOption and Restricted Stock Plan and the SYS 2003 Stock Option Plan, as

 

6

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well as warrants issued for the six month period ended:

 
|                                                                           |   | **December  26, 2003**                     |   |
|--------------------------------------------------------------------------------|--------|--------------------------------------------|--------|
|                                                                           |   | **Options or  Exercise  Price Per  Share** |   | **Weighted  Average  Exercise  Price** |   |
| Balance outstanding at beginning of period                                     |   | 1,846,350                                  |   | $ | 1.17 |   |
|                                                                           |   |                                       |   |   |   |   |
| Granted                                                                        |   | 327,500                                    |   | $ | 1.91 |   |
|                                                                           |   |                                       |   |   |   |   |
| Exercised                                                                      |   | (263,000                                   | )      | $ | 1.00 |   |
|                                                                           |   |                                       |   |   |   |   |
| Cancelled                                                                      |   | (86,500                                    | )      | $ | 1.19 |   |
|                                                                           |   |                                       |   |   |   |   |
| Balance outstanding at end of period                                           |   | 1,824,350                                  |   | $ | 1.33 |   |
|                                                                           |   |                                       |   |   |   |   |
| Price range at end of period                                                   |   | $0.47 to $2.30                             |   |   |   |
|                                                                           |   |                                       |   |   |   |
| Weighted average fair value of options and  warrants granted during the period |   | $                                          | 0.65   | ** ** |   | ** ** |
|                                                                                |        |                                            |        |  |  |  |  |  |

 

In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure—an amendment of SFAS No. 123.” This statement amends SFAS No.123, “Accounting for Stock-Based Compensation,” to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, this statement amends the disclosure requirements of SFAS  No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The company has chosen to continue to account for stock-based compensation using the intrinsic value method prescribed in APB Opinion No. 25 and related interpretations.

 

Accordingly, compensation expense for stockoptions is measured as the excess, if any, of the fair market value of thecompany’s stock at the date of the grant over the exercise price of the relatedoption. The company adopted the annual disclosure provisions of SFAS No. 148 inits financial reports for the year ended June 30, 2003 and the interimdisclosure provisions for its financial reports thereafter.

 

Had compensation costs forthe company’s stock options been determined based on SFAS No. 123, “Accountingfor Stock-Based Compensation,” the company’s net income and earnings per sharewould have been as follows for the three and six months ended December 26, 2003and December 28, 2002, respectively:

 

7

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|                                                                                                                        |   | **Three  months ended** |    | **Six months  ended**   |     |
|-----------------------------------------------------------------------------------------------------------------------------|--------|-------------------------|---------|-------------------------|----------|
|                                                                                                                        |   | **December  26,  2003** |    | **December  28,  2002** |     | **December  26,  2003** |   | **December  28,  2002** |   |
| Net income (loss) - applicable to common  stock - as reported - basic                                                       |   | $                       | 236,000 |                    | $        | (522,000 | ) | $ | 366,000 |   | $ | (463,000 | ) |
| Deduct total stock-based employee  compensation expense determined under fair value - based method for all  awards - basic  |   | 85,000                  |    | 60,000                  |     | 178,000 |   | 116,000 |   |
| Net income applicable to common stock - pro  forma - basic                                                                  |   | $                       | 151,000 |                    | $        | (582,000 | ) | $ | 188,000 |   | $ | (579,000 | ) |
| Net income (loss) - applicable to common  stock - as reported - diluted                                                     |   | $                       | 250,000 |                    | (522,000 | ) | 394,000 |   | (463,000 | ) |
| Deduct total stock-based employee compensation  expense determined under fair value - based method for all awards - diluted |   | 85,000                  |    | 60,000                  |     | 178,000 |   | 116,000 |   |
| Net income applicable to common stock - pro  forma - diluted                                                                |   | $                       | 165,000 |                    | $        | (582,000 | ) | $ | 220,000 |   | $ | (579,000 | ) |
| Basic income per common share:                                                                                              |   |                    |    |                    |     |   |   |   |   |
| As reported                                                                                                                 |   | $                       | 0.04    |                    | $        | (0.10 | ) | $ | 0.06 |   | $ | (0.09 | ) |
| Pro forma                                                                                                                   |   | $                       | 0.03    |                    | $        | (0.12 | ) | $ | 0.03 |   | $ | (0.12 | ) |
| Diluted income per common share:                                                                                            |   |                    |    |                    |     |   |   |   |   |
| As reported                                                                                                                 |   | $                       | 0.03    |                    | $        | (0.10 | ) | $ | 0.04 |   | $ | (0.09 | ) |
| Pro forma                                                                                                                   |   | $                       | 0.02    |                    | $        | (0.12 | ) | $ | 0.03 |   | $ | (0.12 | ) |

 

(3)                                  Notes Payable

 

The Company had a $150,000 note payable tothe Company’s CEO that was paid in full as of June 30, 2003.  This note carried interest at 10% and had amaturity date of October 15, 2003.  Asadditional consideration, the note holder was granted warrants to purchase250,000 shares of common stock at a price of $1.00 per share, the market valueof the Company’s common stock at the grant date. The warrants vestedimmediately and were scheduled to expire 30 days after October 15, 2003. Thewarrants had a fair value of $130,000 as of the date of issuance; accordingly,the Company discounted the note by $130,000 and accreted over the term of thenote.  The Company recognized $54,400and $64,800 of additional interest expense in 2003 and 2002, respectively,related to the accretion of this debt discount. The Company paid $74,595 ofprincipal on the note in fiscal 2003.

 

This note was paid in full as of June 30,2003 and the CEO exercised the 250,000 warrants to purchase the common sharesas discussed more fully in the Stockholders’ Equity Note.

 

During FY 2002, the Company issued three-yearconvertible notes payable in exchange for $1,000,000 in cash to related andunrelated parties.  The notes bearinterest at an annual rate of 10%, mature on various dates starting November 8,2004 and are unsecured.  Each note has aconversion feature whereby the noteholder can convert at any time the unpaidprincipal balance at the rate of $1.00 per share into the Company’s commonstock, which represents the fair value of the common stock on the day the notes

 

8

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were issued.  During fiscal year2004, the Company’s CEO converted $225,000 of such notes (See Note  7). The Company has deferred approximately $105,000 of expenses associatedwith these notes payable, which are included in other assets and are beingamortized over three years. As of December 26, 2003, the total principalbalance of the convertible notes payable to related parties amounted to $137,000and the total owed to unrelated parties amounted to $638,000.

 

During the three months ended December 26,2003, the Company issued a three-year convertible note in the amount of$150,000 to a related party in connection with a subscription offering asdiscussed more fully under Stockholders’ Equity in Note (7).

 

(4)                                  Earnings Per Share

 

Basic net income (loss) per common share iscalculated by dividing net income (loss) applicable to common stock by theweighted average number of common shares outstanding during the period.  The calculation of diluted net income (loss)per common share is similar to that of basic net income (loss) per commonshare, except that the denominator is increased to include the number ofadditional common shares that would have been outstanding if all potentiallydilutive common shares, principally those issuable upon the conversion of notespayable and the exercise of stock options and warrants, were issued during theperiod.

 

The following table summarizes thecalculation of basic and diluted net income (loss) per common share for eachperiod:

 
|                                                                                                                              |   | **Three  months ended** |    | **Six months  ended**   |   |
|-----------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------|---------|-------------------------|--------|
|                                                                                                                              |   | **December  26,  2003** |    | **December  28,  2002** |   | **December  26,  2003** |   | **December  28,  2002** |   |
| Numerators:                                                                                                                       |   |                    |    |                    |   |   |   |   |   |
| Income (loss) from continuing operations                                                                                          |   | $                       | 237,000 |                    | $      | (295,000 | ) | $ | 370,000 |   | $ | (179,000 | ) |
| Deduct - preference dividend requirements  applicable to continuing operations                                                    |   | 1,000                   |    | —                  |   | 4,000 |   | 3,000 |   |
| Income (loss) applicable to common stock  from continuing operations - basic                                                      |   | 236,000                 |    | (295,000                | )      | 366,000 |   | (182,000 | ) |
| Add - interest on convertible notes, net of  tax effects                                                                          |   | 14,000                  |    | —                  |   | 28,000 |   | — |   |
| Income (loss) applicable to common stock  from continuing operations-diluted                                                      |   | 250,000                 |    | (295,000                | )      | 394,000 |   | (182,000 | ) |
|                                                                                                                              |   |                    |    |                    |   |   |   |   |   |
| Loss applicable to common stock from  discontinued operations                                                                     |   | —                  |    | (227,000                | )      | — |   | (281,000 | ) |
| Net income (loss) applicable to common  stock                                                                                     |   | $                       | 250,000 |                    | $      | (522,000 | ) | $ | 394,000 |   | $ | (463,000 | ) |
| Denominators:                                                                                                                     |   |                    |    |                    |   |   |   |   |   |
| Weighted average shares for basic net  income per common share                                                                    |   | 6,033,383               |    | 4,990,879               |   | 5,758,171 |   | 4,958,342 |   |
| Add effects of dilutive securities from  assumed exercise of stock options and warrants and application of treasury  stock method |   | 806,041                 |    | —                  |   | 867,004 |   | — |   |
| Add effects of the conversion of the Company’s  convertible promissory notes                                                 |   | 961,263                 |    | —                  |   | 980,307 |   | — |   |
| Weighted average shares for diluted net  income (loss) per common share                                                           |   | 7,800,687               |    | 4,990,879               |   | 7,605,482 |   | 4,958,342 |   |
| Basic net income (loss) per common share  from continuing operations                                                              |   | $                       | 0.04    |                    | $      | (0.06 | ) | $ | 0.06 |   | $ | (0.04 | ) |
| Basic net (loss) per common share from  discontinued operations                                                                   |   | —                  |    | $                       | (0.04  | ) | $ | — |   | $ | (0.05 | ) |
| Basic net income (loss) per common share                                                                                          |   | $                       | 0.04    |                    | $      | (0.10 | ) | $ | 0.06 |   | $ | (0.09 | ) |
| Diluted net income (loss) per common share  from continuing operations                                                            |   | $                       | 0.03    |                    | $      | (0.06 | ) | $ | 0.05 |   | $ | (0.04 | ) |
|                                                                                                                              |   |                    |    |                    |   |   |   |   |   |
| Diluted net loss per common Share from  discontinued operations                                                                   |   | —                  |    | (0.04                   | )      | $ | — |   | $ | (0.05 | ) |
| Diluted income (loss) per common share                                                                                            |   | $                       | 0.03    |                    | $      | (0.10 | ) | $ | 0.05 |   | $ | (0.09 | ) |

 

Excluded from the table abovein FY 2003 are the Company’s convertible promissory notes that may be convertedinto 1,000,000 shares of common stock at both the quarter and period ends.  Additionally, the table excludes the assumedexercise of stock options and warrants, calculated based on the treasury stockmethod, into 351,998 and 355,676 shares of common stock at the quarter andperiod ends, respectively.

 

9

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(5)                                  Line of Credit andWorking Capital Loan

 

On January 28, 2004, the Company renewed itsline of credit with Comerica Bank-California, increasing the borrowing limitfrom $1,500,000 to $2,000,000 and reducing the interest rate from prime plus0.075% to prime plus 0.025% or an effective rate at renewal of 4%. The renewedagreement expires on December 28, 2004. The loan is collateralized by all of the Company’s assets includingcontract receivables.  ComericaBank-California advances funds to the Company of up to 80% of the Company’sbilled contract receivables that are less than 90 days old.  Comerica Bank-California charges an interestrate of 0.25% over prime or 3.00% above the Bank’s LIBOR.  Comerica Bank-California requires theCompany to maintain certain covenants; as of December 26, 2003, the Company wasin compliance with all of those covenants.

 

At December 26, 2003, the Company had anoutstanding balance of $195,000 under a $500,000 working capital loan providedby the same bank, which expires on January 31, 2005.  The loan is collateralized by substantially all of the assets ofthe Company and also bears interest at 0.75% above the prime rate.

 

(6)                                  Legal Matters

 

On March 19, 2003, the Company was servednotice that it was named in a lawsuit filed in the Superior Court ofCalifornia, County of Orange, on March 10, 2003.  The lawsuit was brought by associates of former Company Chairmanand Chief Executive Officer, Robert D. Mowry who had a relationship with Mowrythrough Big Canyon Investments, Inc. and UniPrise, Inc.  The Plaintiffs are George M. Colin, WilliamCzapar, Dan Birdsall and Brian Patterson. In addition to the Company, the Defendants are Robert Mowry, anindividual; William Zures, an individual; UniPrise, Inc., a Californiacorporation; Acrylis, Inc., a Delaware corporation; Big Canyon Investments,Inc., a California corporation; Caldera International, Inc., a Utah corporationand several Does.

 

The Plaintiffs claim to have suffered lossesand seek damages of the principal amounts of $980,000, plus interest,administrative fees and other consideration. The Company has hired counsel and will vigorously defend thelawsuit.  While the Company believes ithas no liability in this matter, there can be no assurance that the Plaintiffswill not be successful in asserting that the Company is liable to them. 

 

We are involved in legal actions in thenormal course of business, including audits and investigations by variousgovernmental agencies that result from our work as a governmental contractor.We are named as defendants in legal proceedings from time to time and we mayassert claims from time to time.

 

10

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(7)                                  Stockholders’Equity

 

During the first two quarters of FY 2004,there were 13,000 shares of common stock issued due to the exercise of stockoptions for $12,175.  These options hadexercise prices ranging from $0.67 to $1.45.

 

On September 9, 2003, The Board of Directorsauthorized management to call the Company’s 69,781 shares of issued andoutstanding 9% Series B Preference stock. The stockholders were offered cash or an exchange for common stock using$1.75 as the per share price of the common stock.  These shareholders received approximately $60,000 in cash and5,969 shares of common stock with a market value of $10,000.

 

On September 29, 2003, the Companycontributed 62,500 shares of common stock to the Company’s Employee StockOwnership Plan in accordance with the matching provisions under the plan.  These shares had a fair market value of $137,500.

 

On September 29, 2003, the Company issued62,950 shares of common stock to employees that participated in the EmployeeStock Purchase Plan.  The period ofperformance was from January 1, 2003 to June 30, 2003.  These shares had a fair market value of  $138,490.

 

On October 16, 2003, Clifton L. Cooke, Jr.,the Company’s President and CEO, exercised warrants to purchase 250,000 commonshares at $1.00 per common share.  Theseshares had a fair market value of $450,000.

 

On October 20, 2003, Clifton L. Cooke, Jr.,the Company’s President and CEO, converted his $225,000 convertible notes at$1.00 per common share.  These shareshad a fair market value of $405,000.

 

During the three months ended December 26,2003, the Company initiated a subscription offering to raise up to $3,000,000for working capital and acquisition financing. The offering consists of unitscomprised of 50% common stock and 50% convertible notes, bearing interest at10%. The notes are convertible over a three-year period. The common stock waspriced at $1.60 per share, which represents a discount to market at the time ofapproval.  The convertible notes may beconverted to common stock at $2.20 per share, a premium to market at the timeof authorization, at any time during the three-year period.  The offering was commenced in December 2003and as of December 26, 2003 the Company had sold units totaling $300,000 all ofwhich were sold to a member of the Company’s Board of Directors.  As of December 26, 2003, the Company hadalso collected an additional $200,000 in cash from the units offering for unitsthat had not been finalized and therefore were treated as a liability at periodend.  Subsequent to period end, theseunits were completed.

 

Subsequent to December 26, 2003, additionalcash totaling $1,775,000 has been raised under the offering.  A significant portion of the offering hasbeen sold to employees and directors. No compensation charge has been taken since the offering was done forfinancing purposes.

 

Item 2.                                     Management’sDiscussion and Analysis or Plan of Operations

 

To the extent that the information presented in this quarterly reportdiscusses financial projections, information or expectations about our businessplans, results of operations, products or markets, or otherwise makesstatements about future events, such statements are forward-looking.  Such forward-looking statements can beidentified by the use of words such as “intends”, “anticipates”, “believes”,“estimates”, “projects”, “forecasts”, “expects”, “plans” and “proposes”.  Although we believe that the expectationsreflected in these forward-looking statements are based on reasonableassumptions, there are a number of risks and uncertainties that could causeactual results to differ materially from such forward-looking statements.  These include, among others, the cautionarystatements in the “Factors Which May Affect Future Results” and “Management’s

 

11

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Discussion and Analysis or Plan of Operations” sections of thisreport.  These cautionary statementsidentify important factors that could cause actual results to differ materiallyfrom those described in the forward-looking statements.

 

New AccountingPronouncements

 

In May 2003, the Financial Accounting Standards Board (“FASB”) issuedstatement of financial accounting standard (“SFAS”) 150, Accounting for CertainFinancial Instruments with Characteristics of Both Liabilities and Equity. SFAS150 requires that certain financial instruments, which under previous guidancewere accounted for as equity, must now be accounted for as liabilities. Thefinancial instruments affected include mandatory redeemable stock, certainfinancial instruments that require or may require the issuer to buy back someof its shares in exchange for cash or other assets and certain obligations thatcan be settled with shares of stock. SFAS 150 is effective for all financialinstruments entered into or modified after May 31, 2003, and otherwise iseffective at the beginning of the first interim period beginning after June 15,2003. The Company adopted SFAS 150 effective July 1, 2003. The adoption of SFAS150 did not have a material impact on the results of operations, financialposition or liquidity of the Company.

 

In April 2003, the FASB issued SFAS 149, Amendment of Statement 133 onDerivative Instruments and Hedging Activities, which amends and clarifiesfinancial accounting and reporting for derivative instruments, includingcertain derivative instruments embedded in other contracts and for hedgingactivities under SFAS 133. SFAS 149 is effective for contracts entered into ormodified after June 30, 2003. The adoption of SFAS 149 did not have a materialimpact on the results of operations, financial position or liquidity of theCompany.

 

In July 2002, the FASB issued SFAS 146,Accounting for Restructuring Costs. SFAS 146 applies to costs associated withan exit activity (including restructuring) or with a disposal of long-livedassets. Those activities can include eliminating or reducing product lines,terminating employees and contracts, and relocating plant facilities orpersonnel. Under SFAS 146, a company will record a liability for a costassociated with an exit or disposal activity when that liability is incurredand can be measured at fair value.  SFAS146 requires a company to disclose information about its exit and disposalactivities, the related costs, and changes in those costs in the notes to theinterim and annual financial statements that include the period in which anexit activity is initiated and in any subsequent period until the activity iscompleted.  SFAS 146 is effectiveprospectively for exit or disposal activities initiated after December 31,2002. Under SFAS 146, a company may not restate its previously issued financialstatements and SFAS 146 grandfathers the accounting for liabilities that acompany had previously recorded under Emerging Issues Task Force Issue 94-3.The adoption of SFAS 146 did not have a material impact on our results ofoperations, financial position or liquidity.

 

In November 2002, the Emerging Issues Task Force (“EITF”) issued ETIFIssue No 00-21, “Accounting for Revenue Arrangements with MultipleDeliverables.” EITF Issue No. 00-21 addresses how to determine whether arevenue arrangement involving multiple deliverables contains more than one unitof accounting for the purposes of revenue recognition and how the revenuearrangement consideration should be measured and allocated to the separateunits of accounting.  EITF Issue No.00-21 applies to revenue arrangements entered into after June 15, 2003.  The adoption of this statement did not havea material impact on the Company’s financial condition or results ofoperations.

 

In January 2003, the FASB issued Interpretation No. 46. *Consolidation of Variable Interest Entities,*which addresses the consolidation of certain entities (“variable interestentities”) in which an enterprise has a controlling financial interest throughother than voting interests.  FIN No. 46requires that a variable interest entity be consolidated by the holder of themajority of the expected risks and rewards associated with the activities ofthe variable interest entity.  FIN 46was effective for VIE’s entered into prior to February 1, 2003 in periodsbeginning after June 15, 2003.  Theadoption of FIN 46 did not have a material impact on the Company’s financialcondition or results of operation.  InJanuary 2004, the FASB issued a revision to FIN 46, to clarify somerequirements and add new scope exceptions. The revised guidance is effective for the first reporting periodbeginning after December 15, 2003.  Theadoption of the provisions of FIN 46R is not expected to have a material impacton the Company’s financial condition or results of operations.

 

### Description of Business

 

Overview

 

SYS Technologies (“SYS or “the Company”) hasprovided engineering, technical, financial and management services tocommercial and U.S. government customers since 1966. It currently has severalmultiple-year management and engineering service contracts with the U.S. Navyand General Services Administration at various locations across the country.

 

The Company delivers these services through three divisions all ofwhich are classified as one segment under the provisions of SFAS No. 131,  as follows:

 

•                  EnterpriseSolutions Division

•                  IntegratedInformation Solutions Division

•                  SystemsManagement and Engineering Division

 

Our revenues have grown internally by establishing new business unitswith experienced senior executives who have the ability to grow these businessunits and expand our customer base. We expect that this trend willcontinue.  At the same time we willevaluate acquisition opportunities and make acquisitions if the transactionsare in line with our strategy of increasing our core competencies and expandingour customer base.

 

Our operating margins are affectedby the mix of contract types (cost reimbursement, fixed-price or time andmaterials) as well as the mix of prime contracts versus subcontracts.Significant portions of our contracts are time and materials and cost reimbursementcontracts. We are reimbursed for labor hours at negotiated hourly billing ratesand other direct expenses under time and materials contracts and reimbursed forall actual costs, plus a fee, or profit, under reimbursement contracts. Thefinancial risks under these contracts are generally lower than those associatedwith other types of contracts, and margins are also typically lower than thoseon fixed-price contracts. The U.S. government also has awarded us fixed-pricecontracts. Such contracts carry higher financial risks because we must deliverthe products, systems or contract services at a cost below the fixed contractvalue in order to earn a profit. Of our total year to date revenues from ourgovernment business in 2004, approximately 33 % were generated by time andmaterials contracts, approximately 64% were generated by cost reimbursementcontracts and approximately 3% were generated by fixed-price contracts.

 

12

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The Company has severalgovernment contracts that have option and award years that may be exercised bythe government.  The government hasrecently requested proposals on a multiple award contract (MAC) that mayencompass some of the tasking the Company has on its current contracts.  When a MAC is involved, numerous companieswill be awarded contracts and they will compete for future tasking awardedunder the MAC.  The Company hassubmitted proposals for these new contracts as a prime contractor and is alsoincluded as a subcontractor on several other proposals.  Some of the Company’s existing contracts maynot have option or awards years exercised by the government as new tasks areplaced under this MAC.

 

Enterprise Solutions Division

 

TheCompany’s Enterprise Solutions Division is based in Oxnard, California and isadjacent to major Navy activities, which includes the Port Hueneme Division ofthe Naval Surface Warfare Center, the Naval Facilities Expeditionary LogisticsCenter and the Naval Air Warfare Center.

 

ThisDivision performs engineering services, operational analysis and informationtechnology services in support of Navy customers.  Engineering services are in support of combat systems, ships,auxiliary systems, components and equipment.  Operational analysis and services include a full range of businessfunctions performed both at the Company’s facilities for analysis and on thecustomer site for direct support. Information technology services providerequirements determination and analysis, software development, anddocumentation development as well as on-site administration, training and helpdesk operations as a subcontractor to a large Navy prime Information Technologycontractor.

 

ThisDivision had revenue of $8,679,000 or 57% of the Company’s revenue for thefirst two quarters of FY 2004.  Some ofthis Division’s major contracts include:

 

•                  U.S. NavyUnderway Replenishment (UNREP) prime contract that has been held by the Companysince 1982.

 

•                  Management,Planning, Analytical and Administrative (MPAA) prime contract, which supportsthe U.S. Navy’s Port Hueneme Division, Naval Surface Warfare Center. 

 

•                  NavyMarine Corps Intranet (NMCI) subcontract for information technology services. 

 

The MPAA contract’s third option year was due to expire on January 31,2004.  This contract has an additionaloption year that the government has informed the Company it will not beexercising and that the government may re-solicit all or part of thecontract.  On January 26, 2004, thecompany received a 60-day extension on the MPAA contract plus a clean up periodthrough June 30, 2004.  Depending on thenature of any requests for proposal on tasks currently being preformed underthe MPAA contract, the Company may elect to submit a proposal.  For the year to date 2004, this contractaccounted for $2.4 million or approximately 18% of the Company’s revenue.

 

13

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|                           |   | **Three  months ended**     |      | **Six months  ended**       |   |
|--------------------------------|--------|-----------------------------|-----------|-----------------------------|--------|
|                           |   | **December 26,  2003** |      | **December 28,  2002** |   | **December 26,  2003** |   | **December 28,  2002** |   |
| Revenue for division           |   | $                           | 4,296,000 |                        | $      | 4,238,000 |   | $ | 8,679,000 |   | $ | 7,051,000 |   |
| Percent of revenue for Company |   | 56                          | %         | 62                          | %      | 57 | % | 59 | % |
|                                |        |                             |           |                             |        |  |  |  |  |  |  |  |  |

 

(See “Results of Operations for discussion of revenue trend analysis)

 

Integrated Information Solutions Division

 

The Company’s Integrated Information Solutions (IIS) Division is basedin San Diego, California.  This groupprovides Command, Control, Communication, Computer, Intelligence, Surveillanceand Reconnaissance system engineering services and solutions.

 

The customer base includes Space and Naval Warfare Systems Command(SPAWAR) Headquarters, SPAWAR Systems Center San Diego, Naval Air SystemsCommand (NAVAIR), Defense Advanced Research Programs Agency (DARPA), as well asnumerous operational commands and other DOD industry partners such as Boeingand British Aerospace Corporation.  TheIIS personnel work closely with Office of Naval Research, DARPA, AssistantSecretary of the Navy for Research, Development and Acquisition, AdvancedResearch and Development Activity, Chief of Naval Operations, Naval WarfareDevelopment Command, Joint Forces Command, and other services and JointAgencies.

 

This Division had revenue of $3,895,000 or 26% of the Company’s revenuefor the first two quarters of FY 2004. Some of this Division’s major contracts include:

 

•                  Primecontract with SPAWAR Systems Center’s Joint and National Systems Division.  Subcontractors on this contract includeNorthrup-Grumman, Boeing, Lucent, SAIC, and BAE.

 

•                  Subcontractwith Science Applications International Corporation (SAIC) on its SPAWARSystems Engineering & Integration contract. 

 

•                  Primecontract with SPAWAR Systems Center’s Information Assurance and EngineeringDivision.  Subcontractors on thiscontract are Science Applications International Corporation, Booz-Allen &Hamilton, Inc, American Systems Corporation, Galaxy Scientific Corporation andNathan Kunes, Inc.

 
|                           |   | **Three  months ended**     |      | **Six months  ended**       |   |
|--------------------------------|--------|-----------------------------|-----------|-----------------------------|--------|
|                           |   | **December 26,  2003** |      | **December 28,  2002** |   | **December 26,  2003** |   | **December 28,**

**2002** |   |
| Revenue for division           |   | $                           | 2,006,000 |                        | $      | 1,306,000 |   | $ | 3,895,000 |   | $ | 2,382,000 |   |
| Percent of revenue for Company |   | 26                          | %         | 19                          | %      | 26 | % | 20 | % |
|                                |        |                             |           |                             |        |  |  |  |  |  |  |  |  |

 

(See “Results of Operations for discussion of revenue trend analysis)

 

Systems Engineering and Management Division

 

TheCompany’s Systems Engineering and Management Division is based in Arlington,

 

14

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Virginia with a second office located in Chesapeake, Virginia.  A third office is currently beingestablished in San Antonio, Texas.

 

ThisDivision performs Department of Defense Acquisition Program Management, NavyCombat System Safety Engineering, Communications and other InformationTechnology Engineering and Support Services, Port Engineering for shipequipment installations, training, and Budgeting and Financial Management.  Typical systems supported are:  Battle Force Tactical Training (BFTT), FiberOptic Data Multiplex System (FODMS), and the Combat System Operating SequencingSystem (CSOSS).

 

ThisDivision had revenue of $2,636,000 or 17%****ofthe Company’s revenue for the first two quarters of FY 2004.  Some of this Division’s major contractsinclude:

 

•                  Subcontractfor the Naval Sea Systems Command’s Professional Support Services MultipleAward Contract (NAVSEA MAC).

 

•                  Technicalsupport under a GSA contract to the Battle Force Tactical Training (BFTT)program for Naval Sea Systems Command.

 
|                           |   | **Three  months ended**     |      | **Six months  ended**       |   |
|--------------------------------|--------|-----------------------------|-----------|-----------------------------|--------|
|                           |   | **December 26,  2003** |      | **December 28,  2002** |   | **December 26,  2003** |   | **December 28,  2002** |   |
| Revenue for division           |   | $                           | 1,356,000 |                        | $      | 1,286,000 |   | $ | 2,636,000 |   | $ | 2,478,000 |   |
| Percent of revenue for Company |   | 18                          | %         | 19                          | %      | 17 | % | 21 | % |
|                                |        |                             |           |                             |        |  |  |  |  |  |  |  |  |

 

(See “Results of Operations for discussion of revenue trend analysis)

 

All of the above Divisions

 

TheCompany has three contracts from the General Services Administration(GSA).  These three contracts are forInformation Technology, Financial and Business Solutions and ProfessionalEngineering Services.  These contracts,which are time and material based, have proven to be a means to develop newcustomers and these contracts are registered in the GSA Advantage System.  The GSA Advantage System is an on-lineservice provided by GSA that lists the price schedules for all registeredcompanies. Revenues of $ 3,051,908  fromthose contracts are included in the divisional revenues noted above.

 

### Results of Operations

 

The following table sets forthcertain items, including consolidated revenues for the three and six-monthperiods ended for fiscal years 2004 and 2003 (in thousands):

 
|                                |   | **Three Months Ended** |   | **Six Months Ended** |   |
|-------------------------------------|--------|------------------------|--------|----------------------|--------|
|                                |   | **Dec. 26  2003**      |   | **%**                |   | **Dec. 28  2002** |   | **%** |   | **Dec. 26  2003** |   | **%** |   | **Dec. 28  2002** |   | **%** |   |
| Revenues                            |   | $                      | 7,658  |                 | 100.0  |   | $ | 6,830 |   | 100.0 |   | $ | 15,210 |   | 100.0 |   | $ | 11,911 |   | 100.0 |   |
| Costs and expenses:                 |   |                   |   |                 |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Contract costs                      |   | 6,152                  |   | 80.3                 |   | 5,635 |   | 82.5 |   | 12,512 |   | 82.3 |   | 9,773 |   | 82.1 |   |
| General and Administrative expenses |   | 1,088                  |   | 14.2                 |   | 695 |   | 10.2 |   | 2,023 |   | 13.3 |   | 1,392 |   | 11.7 |   |
| Legal settlement                    |   | —                 |   |                 |   | 941 |   | 13.8 |   | — |   |   |   | 941 |   | 7.9 |   |
| Totals                              |   | 7,240                  |   | 94.5                 |   | 7,271 |   | 106.5 |   | 14,535 |   | 95.6 |   | 12,106 |   | 101.6 |   |
| Income (loss) from operations       |   | 418                    |   | 5.5                  |   | (441 | ) | (6.5 | ) | 675 |   | 4.4 |   | (195 | ) | (1.6 | ) |
|                                     |        |                        |        |                      |        |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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Revenues increased approximately 12% and 28%for the three and six month periods for FY 2004, as compared to the sameperiods of FY 2003. Each division had an increase in revenues and the primaryreason for the increase in revenues is additional tasking on existingcontracts.  Collectively, the UNREP($1,000K) and SPAWAR ($1,000K) prime contracts and the NMCI ($1,500K) and SAIC($500K) subcontracts accounted for the increased revenues.

 

Contract costs include all direct costs suchas labor and materials and indirect costs such as subcontractors and overhead.The primary source of revenues for the Company is direct labor withsubcontracting and overhead as secondary sources. Since direct labor is fullyburdened, any increase or decrease in the mix of direct labor to other directcosts from period to period will have a significant impact on revenues andoperating margins.

 

Historically, contract costs run at approximately83% of contract revenues. For the recent quarter ended contract costs wereapproximately 80% of revenues. The lower percentage in the current quarter isattributable to the fact that we had a higher mix of direct labor as part ofthe total contract costs. This is further demonstrated by the growth in directlabor headcount from 261 at the end of the first quarter to 289 at the end ofthe second quarter and the decrease in other direct costs  from $1.9M to $ 1.4M during the same period.

 

General and administrative expenses, whichconsists principally of corporate support, has increased by approximately$393,000 and $ 631,000 or 1.7%, respectively over the same three and six monthperiods in the prior year. The primary reasons for increased costs year to datewere due to additional salaries, audit expenses and estimated accruals forcertain expenses, which collectively accounted for $347,000 or approximately88% of the increase in the current quarter.

 

The increased salariesrelate to key management personnel who are responsible for (i) ensuring theCompany’s ability to comply with the increased costs of being a publicly tradedcompany under the recent Sarbanes-Oxley legislation and (ii) executing on theCompany’s growth strategy including the recent fund raising activities. Auditexpenses have increased significantly and are expected to continue increasingas reporting and compliance obligations have been increased for both theCompany and the independent accountants. The estimated accruals are based on an incentive compensation plan putin place during the current fiscal year.

 

In FY 2003, the Companyincurred internal acquisition costs of $140,000 associated with an acquisition,which were included in the G & A expense during that period, and no such expenseshave been incurred in 2004.

 

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As previously reported,the Company and four employees were sued in Virginia by Systems Integration& Research, Inc. (“SIR”) in February 2002, which claimed that theCompany and the four employees had conspired to divert a contract that SIR wasperforming for the U.S. Navy. In January of 2003, all of SIR’s claimsagainst the Company and the four employees and all of the Company’s claimsagainst SIR and the other defendants were dismissed.

 

In connection with thedismissal of the lawsuit, on January 9, 2003, the Company signed a licenseagreement with C-Cubed Corporation whereby the Company received a five-yearexclusive license to manufacture and sell C-Cubed’s “ViewCASE”.  ViewCASE is a portable, briefcase-sizedvideoconferencing system.  The Companyagreed to pay C-Cubed $150,000 in cash and 302,877 shares, of which 41,325shares were issued subsequent to June 30, 2003, of the Company’s commonstock with a fair value of approximately $600,000.  In addition, the Company incurred approximately $222,118 in legalfees during 2003 in a successful defense of the lawsuit filed against it byC-Cubed, which has been dismissed and settled.

 

There are no furtherobligations on behalf of the Company with regard to that settlement.

 

The Company’s interest expense decreasedapproximately 48% and 38% for the three and six month periods for FY 2004, ascompared to the same periods of FY 2003. Interest expense decreased due to improvements in working capitalresulting in less use of the Company’s line of credit with ComericaBank-California.  Additionally, theaccretion of a debt discount recorded as interest expense was ended in FY 2003.

 

Income from operations improved to $418,000and $ 675,000 for the second quarter and year to date in fiscal year 2004 ascompared to a loss from operations of ($441,000) and ($195,000) for the sameperiods in the prior fiscal year. This improvement is directly attributable tothe elimination of losses from discontinued operations and the legalsettlement. Current year to date operating margins are 4.4%, which isrepresentative of margins for a services based defense contract business.

 

During the first two quarters of FY 2003, theCompany had combined losses of approximately $465,000 in its Training Divisionand Walk-Up Systems Divisions.  As thesedivisions were discontinued at the end of 2003, no such losses were incurred in2004.

 

Income taxes reflect effective rates of 42%in the quarter and year to date in fiscal year 2004, compared to tax benefitsin the prior year due to the losses. The rates in the current year reflect theexpected tax provision rate for the full fiscal year. The expected taxprovision rates are impacted by estimated changes in annual book income and theestimated tax deductibility of certain operating expenses.

 

Net income is $237,000 and $370,000 for thesecond quarter and year to date in fiscal year 2004 as compared to a net lossof ($522,000) and ($460,000) for the same periods in the prior fiscal year. Theimprovement in net income is based on the improved income from operations asdiscussed above.

 

Funded contract backlog (the Company has beenawarded contracts which have been funded by the customer) was approximately$12,125,000 at the end of the second quarter of FY 2004 compared to $9,508,000for the same quarter in FY 2003. The amount of funded backlog at any one timewill generally approximate one to two quarters of revenues.

 

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Liquidity andCapital Resources

 

The Company had net contract receivables of$6,672,000 at the end of the second quarter of fiscal year 2004 and $6,468,000for the same quarter ended in fiscal year 2003. Although revenues grew by 28%from December 26, 2003 compared to the same period in the prior year, contractreceivables have not grown by a similar percentage because of a significantimprovement in collections performance. In the current year, day’s salesoutstanding (DSO’s) have improved to approximately 43 days as compared to 77days at the end of the same quarter in 2003.

 

Cash flow from operating activities was($154,000) as compared to ($581,000) in the prior year. The increase in cashflow is attributable to the improved DSO’s discussed above. Net cash providedby financing activities of $477,000 includes proceeds from issuances of commonstock of $509,000 from: (i) $250,000 from the conversion of warrants exercisedduring the quarter by the Company’s CEO, (ii) $150,000 from the sale of units undera subscription offering initiated during the quarter, (iii) $96,000 from thesale of stock to the employees pursuant to the Company’s Employee StockPurchase Plan and (iv) $13,000 from stock option exercises.

 

The Company had accounts payable of $714,000,consisting mainly of subcontractor invoices, at the end of the second quarterof fiscal year 2004 and $1,793,000 for the same quarter in fiscal year2003.  At the end of the second quarterof fiscal year 2003, the Company had invoices totaling $1,255,000 from onesubcontractor, which accounted for the majority of the significant differencebetween the two periods.

 

In the normal course of operating thebusiness, short-term timing differences arise between when the Company pays itsemployees and subcontractors and when the Company receives payment from itscustomers. Accordingly, the Company utilizes its revolving line of credit tofund these differences.

 

Details of contractual obligations atDecember 26, 2003 are as follows:

 
|                               |   |      |      | **Payments  Due by Period** |   |
|------------------------------------|--------|-----------|-----------|-----------------------------|--------|
|                               |   | **Total** |      | **Less than  1 year**       |   | **1-3 years** |   | **4-5 years** |   | **After 5  years** |   |
| Long-Term debt                     |   | $         | 1,120,000 |                        | $      | 286,000 |   | $ | 834,000 |   | — |   | — |   |
| Operating leases                   |   | 1,830,000 |      | 477,000                     |   | 1,054,000 |   | 299,000 |   | — |   |
| Total contractual cash obligations |   | $         | 2,950,000 |                        | $      | 763,000 |   | $ | 1,888,000 |   | $ | 299,000 |   | — |   |
|                                    |        |           |           |                             |        |  |  |  |  |  |  |  |  |  |  |

 

The Company’s primary source of liquidity isits $2,000,000 revolving line of credit facility under a loan agreement withComerica Bank-California that was renewed on January 28, 2004 and expires onDecember 28, 2004.  The outstandingbalance on the Company’s revolving line of credit was $602,000 at the end ofthe second quarter of FY 2004, which means the Company had $898,000 ofborrowing ability remaining.  At the endof the same period in FY 2003, the line of credit balance was $698,000. Theloan is collateralized by all of the Company’s assets including contractreceivables.  Comerica Bank-Californiaadvances funds to the Company of up to 80% of the Company’s billed contract receivablesthat are less than 90 days old.  Comerica Bank-California charges an interest rate of 0.25% overprime or 3.00% above Bank’s LIBOR, at the Company’s option.  Comerica Bank-California requires theCompany to maintain certain covenants; at this time the Company is incompliance with all of those covenants.

 

Management believes that the Company willhave sufficient cash flow from operations and funds available under therevolving credit agreement with Comerica Bank-California to finance itsoperating and capital expenditure requirements. However, to the extent that theCompany pursues acquisitions to achieve its growth strategy, it will need toraise additional cash or other forms of financing similar to the $3.0 millionsubscription offering that was initiated during this quarter.

 

Certain key factors, some of which are bankcovenants and other ratios used by management, indicating the Company’sfinancial condition include:

 
|                        |   | **December  26, 2003** |      | **June 30,  2003** |   |
|-----------------------------|--------|------------------------|-----------|--------------------|--------|
| Current ratio               |   | 2.19                   |      | 1.92               |   |
| Debt to net worth           |   | 1.07                   |      | 1.49               |   |
| Net worth                   |   | $                      | 4,287,000 |               | $      | 3,079,000 |   |
| Net working capital         |   | $                      | 4,292,000 |               | $      | 3,166,000 |   |
| Debt to total assets        |   | 52                     | %         | 60                 | %      |
| Book value per common share |   | $                      | 0.69      |               | $      | 0.57 |   |

 

The above factors are calculated as follows:The current ratio is derived by dividing total current assets by total currentliabilities.  Debt to net worth iscalculated by dividing total liabilities (total current liabilities plus otherliabilities) by net worth.  Net worth istotal stockholders’ equity.  Net workingcapital is total current assets less total current liabilities.  Debt to total assets is total liabilitiesdivided by total assets.  Book value percommon share is stockholders’ equity related to common shares divided by thenumber of common shares outstanding at the end of the period.

 

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Critical Accounting Policies and Estimates

 

The Company’s discussion andanalysis of its financial condition and results of operations are based uponits consolidated financial statements, which have been prepared in accordancewith accounting principles generally accepted in the United States.  The preparation of these financialstatements requires management to make estimates and judgments that affect thereported amounts of assets, liabilities, revenues and expenses, and relateddisclosure of contingent liabilities. On an ongoing basis, management evaluates its estimates, including thosethat relate to revenues,  bad debts,inventory, intangible assets, income tax contingencies, stock basedcompensation and litigation.  Managementbases its estimates on historical experience and on various other assumptionsthat are believed to be reasonable under the circumstances, the results ofwhich form the basis for making judgments about the carrying values of assets andliabilities that are not readily apparent from other sources.  Actual results may differ from theseestimates under different assumptions and conditions.  If actual results significantly differ from management’sestimates, the Company’s financial condition and results of operations could bematerially impaired.

 

The Company believes the following criticalaccounting policies affect its more significant judgments and estimates used inthe preparation of its consolidated financial statements.

 

Revenues are primarilyderived from contracts with agencies of the U.S. Government.  Revenues on fixed-price contracts arerecorded on the percentage completion method in the ratio that costs incurredbear to total estimated costs at completion. Revenues on cost-reimbursement contracts are recorded as costs areincurred and include estimated earned fees in the proportion that costs orhours incurred to date bear to total estimated costs or hours, respectively, asspecified by each contract.  Revenues ontime-and-materials contracts are recorded based on hours incurred, extended atcontract rates plus material expenses and other direct costs incurred.  Contract costs, including indirect costs, oncertain U.S. Government contracts are subject to audit by the Defense ContractAudit Agency before final acceptance. Revenues have been recorded at amounts expected to be realized uponfinal settlement.

 

Ouraccounts receivables balances include unbilled receivables which are comprisedof work-in-process which will be billed in accordance with contract terms anddelivery schedules, as well as amounts billable upon final execution ofcontracts, contract completion, milestones or completion of rate negotiations.Payments to us for performance on certain of our U.S. Government contracts aresubject to audit by the DCAA, and are subject to government funding. We providea reserve against our receivables for estimated losses that may result fromrate negotiations, audit adjustments, and/or government funding availability.To the extent that actual adjustments due to rate negotiations, auditadjustments, or government funding availability differ from our estimates, ourrevenue may be impacted.

 

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Sincethe Company’s primary customer is the U.S. Government, the Company historicallyhas not recorded significant charges for bad debt.  Bad debts are recognized in the period in which they areidentified.

 

The carrying value of theCompany’s net deferred tax assets assumes that the Company will be able togenerate sufficient future taxable income, based on estimates andassumptions.  If these estimates andassumptions change in the future, the Company may be required to recordvaluation allowances against its deferred tax assets resulting in additionalincome tax expenses.

 

In assessing the recoverability of the Company’s intangible assets, theCompany must make estimates of expected future cash flows and other factors todetermine the fair market value of the respective assets.  If these estimates and their relatedassumptions change in the future, the Company may be required to recordimpairment charges.  The Company adoptedStatement of Financial Accounting Standards No. 142, Goodwill and OtherIntangible Assets, and will be required to analyze its goodwill for impairmenton an annual basis.  The Companyrecorded impairment charges for Goodwill in FY 2003 of approximately $84,000.

 

Item 2a.       Factors Which May Affect Future Results

 

Information contained in this Form 10-QSB should be studied carefullyby any shareholder or potential investor while considering the following riskfactors to the Company.

 

**We dependupon a single customer, the U.S. government, for most of our revenues, and adecrease in its demand for our services might harm our operating results.**

 

Asubstantial part of our business at the present time is with the U.S. Navy.Even though the level of business with this customer is growing and we havenegotiated multiple-year contracts that include option and award years, thereis no certainty that budget changes in Congress or the Department of Defense(“DoD”) will not seriously affect us. In addition, there is no certainty that the government will exerciseeach option or award year available on a contract.

 

**Most of ourcustomers are government agencies subject to unique political and budgetaryconstraints and have special contracting requirements that may affect ourability to obtain new government customers.**

 

Mostof our customers are government agencies, principally DoD agencies. Theseagencies often do not set their own budgets and therefore have little controlover the amount of money they can spend. In addition, these agencies experiencepolitical pressure that may dictate the manner in which they spend money. Dueto political and budgetary processes and other scheduling delays thatfrequently occur in the contract or bidding process, some government agencyorders may be canceled or substantially delayed, and the receipt of revenues orpayments may be substantially delayed.

 

Inaddition, future sales to government agencies will depend on our ability tomeet government contracting requirements, certain of which may be onerous orimpossible to meet, resulting in our inability to obtain a particular contract.Common requirements in government contracts include bonding; provisionspermitting the purchasing agency to modify or terminate at

 

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willthe contract without penalty and provisions permitting the agency to performinvestigations or audits of our business practices.

 

**Anyinability to adequately retain or protect our employees, customer relationshipsand proprietary technology could harm our ability to compete.**

 

Our future success and ability to compete depends in part upon ouremployees, customer relationships, proprietary technology and trademarks, whichwe attempt to protect with a combination of patent, copyright, trademark andtrade secret claims, as well as with our confidentiality procedures andcontractual provisions. These legal protections afford only limited protectionand are time-consuming and expensive to obtain and/or maintain. Further,despite our efforts, we may be unable to prevent third parties from solicitingour employees or customers or infringing upon or misappropriating ourintellectual property.  Our employees,customer relationships and intellectual property may not be adequate to provideus with a competitive advantage or to prevent competitors from entering themarkets for our products and services. Additionally, our competitors couldindependently develop non-infringing technologies that are competitive with,and equivalent or superior to, our technology. Monitoring infringement and/ormisappropriation of intellectual property can be difficult, and there is noguarantee that we would detect any infringement or misappropriation of ourproprietary rights. Even if we do detect infringement or misappropriation ofour proprietary rights, litigation to enforce these rights could cause us todivert financial and other resources away from our business operations.

 

**Thedeparture of certain key personnel could harm the financial condition of theCompany.**

 

Clifton L. Cooke, Jr., Michael W. Fink, Linda E. Gagnon, Edward M.Lake, Kenneth D. Regan and Charles E. Vandeveer, are intimately involved in ourbusiness and some have day-to-day relationships with critical customers. SYS isnot able to afford additional staff to supplement these key personnel.Competition for highly skilled business, product development, technical andother personnel is intense, and there can be no assurance that we will besuccessful in recruiting new personnel or in retaining our existing personnel.A failure on our part to retain the services of these key personnel could havea material adverse effect on our operating results and financial condition. Wedo not maintain key man life insurance on any of our employees.

 

**Weface numerous competitors.**

 

We have many competitors with comparable characteristics andcapabilities that compete for the same group of customers. Our competitors arecompetent and experienced and are continuously working to take projects awayfrom us. Some of our competitors have greater financial, technical, marketingand other resources than we do. Our ability to compete effectively may beadversely affected by the ability of these competitors to devote greaterresources to the sales and marketing of their products and services than areavailable to us.

 

**Wemust comply with numerous Government Regulations.**

 

The Company could become liable for penalties under various procurementrules and regulations.  Changes ingovernment regulations could harm our operating results.  Our business must comply with and isaffected by various government regulations. Among the most

 

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significantregulations are:

 

•                  theFederal Acquisition Regulations, and agency regulations supplemental to theFederal Acquisition Regulations, which comprehensively regulate the formation,administration and performance of government contracts;

 

•                  theTruth in Negotiations Act, which requires certification and disclosure of allcost and pricing data in connection with contract negotiations;

 

•                  governmentaccounting regulations, which impose accounting requirements that govern ourright to reimbursement under certain cost-based government contracts; and

 

•                  laws,regulations and executive orders restricting the use and dissemination ofinformation classified for national security purposes and the exportation ofcertain products and technical data.

 

**Accuracy of Indirect Billing Rates iscritical.**

 

The Company’s indirect billing rates are approved at least annually bythe Defense Contract Audit Agency (DCAA). These rates can differ from the Company’s actual indirect rates.  The Company budgets to have its actualindirect rates as close as possible to its DCAA approved indirect rates atfiscal year end.  If the actual indirectrates at year-end are materially different from the DCAA approved indirectrates, the Company would have to recognize that difference at year-end, whichcould affect the Company’s results of operations.

 

**We Rely on Subcontractors.**

 

The Company regularly employs subcontractors to assist us in satisfyingour contractual obligations. If these subcontractors fail to adequately performtheir contractual obligations, our prime contract performance and our abilityto obtain future business could be materially and adversely impacted.

 

Our performance of government contracts may involve the issuance ofsubcontracts to other companies upon which we rely to perform all or a portionof the work we are obligated to deliver to our customers.  There is a risk that we may have disputeswith subcontractors concerning a number of issues including the quality andtimeliness of work performed by the subcontractor, customer concerns about thesubcontractor, our decision not to extend task orders or issue new task ordersunder a subcontract, or our hiring of former personnel of a subcontractor.  A failure by one or more of our subcontractorsto satisfactorily deliver on a timely basis the agreed-upon supplies and/orperform the agreed-upon services may materially and adversely impact ourability to perform our obligations as a prime contractor.  In extreme cases, such subcontractorperformance deficiencies could result in the government terminating ourcontract for default.  A defaulttermination could expose us to liability for excess costs of procurement by thegovernment and have a material adverse effect on our ability to compete forfuture contracts and task orders.

 

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**Security Clearances are necessary.**

 

If the Company cannot obtain the necessary security clearances, we maynot be able to perform classified work for the government and our revenues maysuffer.  Certain government contractsrequire our facilities and some of our employees, to maintain securityclearances.  If we lose or are unable toobtain required security clearances, the client can terminate the contract ordecide not to renew it upon its expiration. As a result, to the extent we cannot obtain the required securityclearances for our employees working on a particular contract, we may notderive the revenue anticipated from the contract, which, if not replaced withrevenue from other contracts, could seriously harm our operating results.

 

Security breaches in sensitive government systems could result in theloss of clients and negative publicity. Many of the systems we develop involve managing and protecting informationinvolved in national security and other sensitive government functions.  A security breach in one of these systemscould cause serious harm to our business, could result in negative publicityand could prevent us from having further access to such critically sensitivesystems or other similarly sensitive areas for other government clients.

 

**There are risks associated with our planned growth.**

 

Weplan to grow the Company’s revenues and profits by adding to our existingcustomer base through internal growth and by the acquisition of othergovernment services or technology related companies.  Over the past twoyears we have hired senior management personnel capable of establishing newbusiness units within the Company.  The San Diego Operations Division wasestablished during FY 2001 and has grown steadily since inception.  TheEast Coast Operations Division was established during FY 2002 and has alsogrown steadily since inception.  Both of these divisions were started withno assurance that they would develop into successful business units. Rapid expansion through internal growth has required additional capitalresources.  We plan to continue this approach to building our governmentservices business.  There can be no assurance that this approach will resultin increased profitability in the future.

 

Managementbelieves that SYS can grow through the acquisition of other government servicesor technology related companies as part of a “roll-up” strategy.  Theacquisition of other companies is uncertain and contains a variety of businessrisks, including:  cultural differences, the retention of key personnel,competition, protection of intellectual property, profitability, industrychanges and others.  Although we do nothave an agreement to acquire any specific company at this time, we intend toattempt to expand our operations through the acquisition of other companies.Acquisitions and attempted acquisitions may place a strain on our limitedpersonnel, financial and other resources. Our ability to manage this growth,should it occur, will require expansion of our capabilities andpersonnel.  We may not be able to find qualified personnel to filladditional positions or be able to successfully manage a larger organization.

 

Wehave very limited assets upon which to rely for adjusting to businessvariations and for growing new businesses. While we are likely to look for newfunding to assist in the acquisition of other profitable businesses, it isuncertain whether such funds will be available. Our substantial reliance on ourrevolving line of credit with Comerica Bank - California imposes certainlimitations on us. If we are to grow and expand our operations, we will need toraise significant amounts of additional capital. There can be no assurance thatwe will be successful in

 

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raisinga sufficient amount of additional capital, or if we are successful, that wewill be able to raise capital on reasonable terms. If we do raise additionalcapital, our existing shareholders may incur substantial and immediatedilution.

 

**There are a large number of shares that maybe available for future sale, and the sale of these shares may depress themarket price of our common stock.**

 

Asof December 26, 2003, we had issued 6,213,662 shares of common stock,convertible promissory notes that may be converted into 815,909 shares ofcommon stock at prices ranging from $1.00 to $2.20 per share, and 2,500warrants to purchase common stock at a price of $1.00 per share. In addition,the Company has issued 1,821,850 exercisable stock options for the acquisitionof shares of common stock at various prices. The sale of shares issued upon any conversion of our outstandingconvertible notes or the exercise of outstanding options or warrants couldadversely affect the market price of our common stock.

 

**There is alimited market for our common stock.**

 

Ourcommon stock is traded in the Over-the-Counter Bulletin Board market, and thismay cause delays in the timing of transactions and reductions in the number andquality of securities analysts’ reporting on the Company and the extent of ourcoverage in the media. Trading in our common stock has been sporadic, and atpresent, there is a limited market for it. There can be no assurance that a strongermarket will develop. Even if such a market does develop, it may not besustained.  There are no analystscurrently covering the Company.

 

**Futuresales of our common stock by existing shareholders under Rule 144 coulddecrease the trading price of our common stock.**

 

Asof December 26, 2003, a total of 2,809,129 shares of our outstandingcommon stock were “restricted securities” and could be sold in the publicmarkets only in compliance with Rule 144 adopted under the Securities Act of1933 or other applicable exemptions from registration. Rule 144 provides that aperson holding restricted securities for a period of one year may thereaftersell, in brokerage transactions, an amount not exceeding in any three-monthperiod the greater of either (i) 1% of the issuer’s outstanding common stock or(ii) the average weekly trading volume in the securities during a period offour calendar weeks immediately preceding the sale. Persons who are notaffiliated with the issuer and who have held their restricted securities for atleast two years are not subject to the volume limitation. Possible or actualsales of our common stock by present shareholders under Rule 144 could have adepressive effect on the price of our common stock.

 

**Ourdirectors and executive officers beneficially own approximately 34.1% of ourstock, including stock options and warrants exercisable within 60 days ofDecember 26, 2003; their interests could conflict with yours; significantsales of stock held by them could have a negative effect on our stock price;shareholders may be unable to exercise control.**

 

Asof December 26, 2003, our executive officers, directors and affiliatedpersons were the beneficial owners of approximately 57.5% of our common stock,including stock options exercisable within 60 days of December 26, 2003.As a result, our executive officers, directors and affiliated persons will havesignificant ability to:

 

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• elect or defeat the election of ourdirectors;

• amend or prevent amendment of our articles ofincorporation or bylaws;

• effect or prevent a merger, sale of assets or other corporate transaction;and

• control the outcome of any other matter submitted to the shareholders forvote.

 

As a result of their ownership and positions, our directors andexecutive officers, collectively, are able to significantly influence allmatters requiring shareholder approval, including the election of directors andapproval of significant corporate transactions. In addition, sales of significantamounts of shares held by our directors and executive officers, or the prospectof these sales, could adversely affect the market price of our common stock.Management’s stock ownership may discourage a potential acquiror frommaking a tender offer or otherwise attempting to obtain control of us, which inturn could reduce our stock price or prevent our shareholders from realizing apremium over our stock price.

 

**Our common stock is subject to “penny stock”rules.**

 

Our common stock is classified as a penny stock by the Securities andExchange Commission. This classification severely and adversely affects themarket liquidity for our common stock. The Commission has adopted Rule 15g-9,which establishes the definition of a “penny stock,” for the purposes relevantto us, as any equity security that has a market price of less than $5.00 pershare or with an exercise price of less than $5.00 per share, subject tocertain exceptions. For any transaction involving a penny stock, unless exempt,the rules require: (i) that a broker or dealer approve a person’s account fortransactions in penny stocks; and (ii) the broker or dealer receive from theinvestor a written agreement to the transaction, setting forth the identity andquantity of the penny stock to be purchased. In order to approve a person’saccount for transactions in penny stocks, the broker or dealer must (i) obtainfinancial information and investment experience objectives of the person; and(ii) make a reasonable determination that the transactions in penny stocks aresuitable for that person and the person has sufficient knowledge and experiencein financial matters to be capable of evaluating the risks of transactions inpenny stocks. The broker or dealer must also deliver, prior to any transactionin a penny stock, a disclosure schedule prepared by the Commissionrelating to the penny stock market, which, in highlight form, sets forth (i)the basis on which the broker or dealer made the suitability determination and(ii) that the broker or dealer received a signed, written agreement from theinvestor prior to the transaction. Disclosure also has to be made about therisks of investing in penny stocks in public offerings and secondary tradingand about the commissions payable to the broker-dealer and registeredrepresentative, current quotations for the securities and the rights andremedies available to an investor in cases of fraud in penny stocktransactions. Finally, monthly statements have to be sent disclosing recentprice information for the penny stock held in the account and information onthe limited market in penny stocks.

 

Item 3.             Controls and Procedures

 

TheCompany maintains certain disclosure controls and procedures that are designedto ensure that information required to be disclosed in the Company’s ExchangeAct reports is recorded, processed, summarized and reported within the timeperiods specified by the Securities and Exchange Commission and that suchinformation is accumulated and communicated to the Company’s management, includingClifton L. Cooke, Jr., the Company’s Chief Executive Officer,

 

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and Edward M.Lake, the Company’s Chief Financial Officer, as appropriate, to permit timelydecisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, theCompany’s management recognizes that any controls and procedures, no matter howwell designed and implemented, can provide only reasonable assurance ofachieving the desired control objectives, and management’s duties require it tomake its best judgment in evaluating the cost-benefit relationship of potentialcontrols and procedures.

 

TheCompany and its management, including its Chief Executive Officer and ChiefFinancial Officer, engage in a variety of procedures to evaluate theeffectiveness of the design and implementation of the Company’s disclosurecontrols and procedures.

 

Asnoted in the Company’s Form 10-KSB for the year ended June 30, 2003,certain “material weaknesses” (as defined under standards established by theAmerican Institute of Certified Public Accountants) were identified which, ifnot corrected, could result in accounting errors or impair our ability toaccurately report our financial statements in a timely manner.  During the first and second quarters of FY2004, management took steps to remedy these deficiencies and will continue tomonitor and evaluate further improvements.

 

Based upon that evaluation and the steps noted above, Messrs Cooke andLake concluded that as of December 26, 2003, the Company’s disclosurecontrols and procedures were reasonably effective in timely alerting them tomaterial information relating to the Company required to be included in itsperiodic filings with the Securities and Exchange Commission.

 

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PART II - OTHERINFORMATION

Item 1.             Legal Proceedings

 

On March 19, 2003, the Company was served notice that it was namedin a lawsuit filed in the Superior Court of California, County of Orange, onMarch 10, 2003.  The lawsuit wasbrought by associates of former Company Chairman and Chief Executive Officer,Robert D. Mowry who had a relationship with Mowry through Big CanyonInvestments, Inc. and UniPrise, Inc. The Plaintiffs are George M. Colin, William Czapar, Dan Birdsall andBrian Patterson.  In addition to theCompany, the Defendants are Robert Mowry, an individual; William Zures, anindividual; UniPrise, Inc., a California corporation; Acrylis, Inc., a Delawarecorporation; Big Canyon Investments, Inc., a California corporation; CalderaInternational, Inc., a Utah corporation and several Does.

 

The Plaintiffs claim to have suffered losses and seek damages of theprincipal amounts of $980,000, plus agreed interest, administrative fees and otherconsideration.  The Company has hiredcounsel and will vigorously defend the lawsuit.  While the Company believes it has no liability in this matter,there can be no assurance that the Plaintiffs will not be successful inasserting that the Company is liable to them. The Company is not able to predict the outcome of this litigation andthere can be no assurance that the Company will not incur substantial andprotracted litigation costs.

 

Item 2.             Changes in Securities

 

During the first two quarters of FY 2004,there were 13,000 shares of common stock issued due to the exercise of stockoptions for $12,175.  These options hadexercise prices ranging from $0.67 to $1.45.

 

On September 9, 2003, The Board of Directors authorized managementto call the Company’s 69,781 shares of issued and outstanding 9% Series BPreference stock.  The stockholders wereoffered cash or an exchange for common stock using $1.75 as the per share priceof the common stock.  These shareholdersreceived approximately $60,000 in cash and $10,000 worth of common stock.

 

On September 29, 2003, the Company issued 62,500 shares of commonstock to the Company’s Employee Stock Ownership Plan as its contribution forthe first quarter of FY 2004.  Theseshares had a fair market value of $137,500.

 

On September 29, 2003, the Company issued 62,950 shares of commonstock to employees that participated in the Employee Stock Purchase Plan.  The period of performance was fromJanuary 1, 2003 to June 30, 2003. These shares had a fair market value of $138,490.

 

On October 16, 2003, Clifton L. Cooke, Jr., the Company’sPresident and CEO, exercised 250,000 warrants at $1.00 per common share.  These shares had a fair market value of$450,000.

 

On October 20, 2003, Clifton L. Cooke, Jr., the Company’s Presidentand CEO, converted his $225,000 note at $1.00 per common share.  These shares had a fair market value of$405,000.

 

The Board of Directors finalized the terms of a subscription offeringat their November 6, 2003 meeting. The resolution called for the offering to raise up to $3,000,000; halfin Company

 

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common stock and half in a three-year convertible note bearing interestat 10%.  The common stock is valued at$1.60 per share.  The convertible notesmay be converted to common stock at $2.20 per share.  As of December 26, 2003, the Company had completed $300,000of its subscription offering.

 

Item 3.             Defaults Upon Senior Securities

 

None.

 

Item 4.             Submission of Matters to a Vote ofSecurities Holders

 

On January 22, 2004, the Company held its 2003 Annual Meeting ofShareholders.  There were 6,112,443shares eligible as of the record date and 4,670,882 shares were representedeither in person or by proxy at the meeting. The following matters were voted on at the meeting:

 

(a.) Proposal to elect the Directors pursuant to management=snominations.  This proposal was approvedwith 4,664,215 shares voting in favor, 6,667 shares voting against.

 

(b.) Proposal to approve the appointment of KPMG LLP as the independentpublic accountants for the corporation for its 2004 fiscal year.  This proposal was approved with 4,637,161shares voting in favor, 17,725 shares voting against, and 15,996 sharesabstaining.

 

Item 5.             Other Information

 

At the Regular Board of Directors meeting held on January 22,2004, the following were elected as Chairman and Officers of the Company:

 
| David A. Derby        |   | Chairman                              |
|-----------------------|--------|---------------------------------------|
| John M. Burns         |   | Vice-Chairman                         |
| Clifton L. Cooke, Jr. |   | President and Chief Executive Officer |
| Edward M. Lake        |   | Chief Financial Officer               |
| Michael W. Fink       |   | Secretary                             |
| Robert A. Babbush     |   | Assistant Secretary                   |

 

 

At the Regular Board of Directors meeting held on January 22,2004, the following were elected as Chairman and Members of the Board ofDirectors’ Committees:

 
| Audit Committee:         |   | Executive Committee:       |
|--------------------------|--------|----------------------------|
| Thomas A. Page, Chairman |   | David A. Derby, Chairman   |
| David A. Derby           |   | John M. Burns              |
| John R. Hicks            |   | Clifton L. Cooke, Jr.      |
|                     |   |                       |
| Compensation Committee:  |   | Senior Advisory Committee: |
| John M. Burns, Chairman  |   | Alfred M. Gray             |
| Thomas A. Page           |   | Clifton L. Cooke, Jr.      |
| David A. Derby           |   | John R. Hicks              |

 

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Item 6.                                     Exhibits and Reports on Form 8-K

 

(a)   List of exhibits

 

31.1         Certification of ChiefExecutive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2         Certification of ChiefFinancial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1         Certification of ChiefExecutive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2         Certification of ChiefFinancial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 

(b)   Reports on Form 8-K

 

On a report dated December 10, 2003, the Company stated that upon therecommendation of its Audit Committee, it had elected to engage KPMG LLP("KPMG") to serve as the Company's principal public accountants forfiscal year 2004.

 

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SIGNATURES

 

In accordance with the requirements of the Exchange Act, the registrantcaused this report to be signed on its behalf by the undersigned, thereuntoduly authorized.

 

 
|   |                        | SYS                     |
|--------|-----------------------------|-------------------------|
|   |                        | (Registrant)            |
|   |                        |                    |
|   |                        |                    |
| Date:  |  February 9, 2004 |                    |   |  /s/ Clifton L. Cooke, Jr. |   |
|   |                        |                    |   | Clifton L. Cooke, Jr. |
|   |                        |                    |   | Chief Executive Officer |
|   |                        |                    |   |   |
|   |                        |                    |   |   |
| Date:  |  February 9, 2004 |                    |   |  /s/ Edward M. Lake |   |
|   |                        | Edward M. Lake          |
|   |                        | Chief Financial Officer |

 

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